· OGDC’s valuations have remained relatively downward sticky likely due to supply flush from foreign selling of around 52mn shares (8.1% of free float) in Apr-18 and resultant dip in domestic appetite for the stock.

· While current intl oil prices offer a significant upside for the stock, we remain skeptical on their sustainability and continue to anchor our valuations and EPS projections at USD60/bbl. Falling oil prices may result in rout in valuations of E&Ps where OGDC is expected to be more resilient due to relative undervaluation compared to other E&P stocks.

Selling Pressures Keeping a Lid on Stock Price: Oil & Gas Development Company (OGDC) has underperformed E&P stocks as it returned 18%/-1% during FYTD/CYTD compared with E&P sector ex-OGDC’s return of 37%/8% during FYTD/CYTD. The dismal performance is likely attributable to ample free float and foreign selling pressures. OGDC has fallen 11% from its calendar year high (April 12, 2018) even though oil prices rose 10% and PKR depreciated by 5% during this period, likely due to supply flush from foreign selling of around 52mn shares (8.1% of free float) on April 16, 2018 and resultant dip in domestic appetite for the stock. The biggest chunk of the block was absorbed by mutual funds as they mopped 9mn shares. This drove up OGDC’s shareholding in mutual funds by 10%MoM to 100mn shares in Apr-18 (a level maintained into May-18).

Lower Risk of Rout due to Undervaluation: While current international oil prices offer a significant upside for the stock, we remain skeptical on their sustainability and continue to anchor our valuations and EPS projections at USD60/bbl. Falling oil prices may result in rout in valuations for domestic E&P stocks where OGDC is expected to be more resilient due to relative undervaluation compared to other E&P’s. In this regard, we estimate OGDC to be currently trading at implied oil price of USD32/bbl which is at 58% discount to international oil prices.

The stock has traded in the PE band of 7-10x in recent years while it has fallen from a PE of 9x to 8x since the off-market stake sale in Apr-18. We believe that cheaper valuation is attributable to supply overhang and relatively lower ‘incremental’ appetite for the stock as locals remain overweight (OGDC’s holding in mutual funds stood at 7% as at May-18 compared to a weight of 5% in KSE-100 Index).

Having a large asset base has its own merits and demerits, and while OGDC has for the past few years failed to leverage its asset base, the future cannot be expected to stay the same. As we update our oil price assumption for FY19/20F to US$70/65/bbl and US$55/bbl thereafter, and PkR/USD parity to reflect the recent devaluations, we believe the recent round of seismic acquisition and fast track exploration program in the concessions can turn the tables. South and Central Balochistan are few areas where recent seismic activities have been concentrated and as the company progresses to phase II of the work programs in a high oil price environment, a host of exploration wells would be spudded. In addition, news flows regarding an offshore oil well (Kekra-1) in a JV operated block poses a high risk to the company’s financials, where cost of the well can go as high as US$90mn. In this regard, we await management guidance post FY18 results to account for such updates in our model. Our updated FY18/19F EPS stand at PkR18.29/20.93/sh, while our rolled forward FY19 TP of PkR210/sh offers an upside of 41.8%.

Focus on the future: Despite having 50 owned and operated concession blocks, OGDC has been unable to unearth a sizable hydrocarbon discovery since FY10 (Nashpa being the last big discovery in its operated block). However, it should be noted that over 90% of the drilling activity had been concentrated in areas of Sindh and KPK, leaving a huge area of Balochistan and some areas of Punjab potentially untouched. As we mentioned previously, seismic acquisition had already begun in many of the concessions awarded in 2013 bidding round (including Zorgarh, Palantak, Rakhshan etc.), and as the company enters into phase II of the work program, we could expect exploration wells in the aforementioned areas. That said, positive outcomes will replace natural declines in many of the fields, while aiding towards higher revenue and profitability based on PP12 policy. However, it will take considerable time before results materialize and pipeline connections are made to the producing areas, as difficult terrains can be a potential deterrent. Notwithstanding all these, salaries and wages will see a huge jump as the crew gets compensated for operating in those areas and so will the depreciation expense going forward.

Offshore drilling is a huge risk: Having played on its home ground (of Sindh) for a long time, the JV of OGDC, PPL, ExxonMobil under the operatorship of ENI has planned to spud a well in Offshore Indus-G block, which falls in the ultra-deep zone. While this comes at a time when oil prices touch their ~4 year highs, the cost of well can go up to US$90mn. Given 25% share of OGDC, risk and return profile for the venture remains high. It must be highlighted that although news flows suggest spud date to be in Jan’18, there are no traces of any seismic data acquisition in the PPIS data, however, the well could be spudded based on reprocessing of previous data. In any case, we await management views post announcement of FY18 results before giving a detailed outlook on the same.

Investment Perspective: Trading at an FY18 forward EV/EBITDA multiple of 4.5x vs 3 year average of 5.6x, we believe the market is significantly discounting OGDC’s current reserves and production capability. Moreover, as its older (gas) fields mature, higher pricing on the new ones offset more than 1.5MMCFD of older gas by 1 MMCFD from a new source. Our revised FY18/19E EPS assumptions stand at PkR18.29/20.93/sh, with our rolled forward FY19 TP of PkR210/sh providing an upside potential of 41.8%.

With expected cumulative YoY earnings growth of 31% in FY19, the recent round of currency devaluation coupled with interest rate hike is set to amplify the revenue stream of Pakistan's E&P sector going forward. OGDC/PPL/POL are currently trading at FY19F P/E of 6.28/7.05/8.00x, as compared to the sector's (3-yr avg.) historical P/E of 9.32x. Index heavyweights (OGDC and PPL) now offer capital upsides of 45.7/32.9% at our FY19/20F intl. oil assumptions of US$70/65/bbl and long term forecast intact at US$55/bbl. Significant contribution to PPL's and OGDC's bottom-lines also emanate from exchange gains. Moreover, higher interest rate environment provides additional return on bank deposits and other investments as E&P companies have historically remained cash rich with financial assets representing 24.4/25.4% of the total asset base in FY17/9MFY18. Having said this, we continue to push for OGDC and PPL, and while POL is trading below its fair value, we believe Jhandial's declining production and probability of dry wells cast concerns over its outlook, hence should be gradually offloaded as it derives ~40% of its value through this well only. Our FY19 TPs for OGDC/PPL/POL are PkR217/276/693/sh, respectively.

Exchange gain is another item to cherish: Movements in FX rates not only trigger top-line growth, but trickle down through other income as well. Refineries procure oil on credit from E&P companies, leaving a net asset exposure where the lag in payment effectively translates into exchange gains for these companies. This item is expected to add PkR0.42/1.33/3.43sh towards OGDC/PPL/POL's EPS projection for FY19F. However, owing to its accounting policy, POL records a subsequent exchange loss on US$ denominated "provision for decommissioning cost" (and thereby nullifies the exchange gain) while PPL and OGDC gradually amortise the corresponding capitalized asset entry over a longer period, effectively gaining from PkR devaluations.

Leveraging the cash rich balance sheet: Cash, bank balance and investments effectively represent 26.6/22.1/31.8% of OGDC/PPL/POL's 9MFY18 overall assets. In this purview, hike in interest rates creates another opportunity for bottom-line accretion as return on investment rises. We have assumed OGDC to reinvest the TFC proceeds in high yielding long term government certificates, while PPL and POL should get higher returns on TDRs translating into other incomes of PkR2.32/2.52/2.35/sh for FY19F. We believe liquid returns from this head can easily be paid out as cash dividends even in the case of outstanding receivables (especially for OGDC).

Investment Perspective: Incorporating our revised assumptions, OGDC/PPL/POL's EPS estimates stand at PkR23.5/29.45/78.72/sh for FY19F. Recent changes in Pakistan macro assumptions have been a blessing for the sector, and valuations have become more attractive. At current levels, OGDC is our best pick with a capital upside of 45.7%, while PPL follows with 32.9% upside potential. POL, however, is trading at a premium as compared to its counterparts despite i) hydrocarbon flows from Jhandial being reduced to 1/3rd of its original (where Jhandial makes up ~40% of POL's value) and ii) industry sources indicating no economic benefit of the ongoing exploration wells, hence we believe should be gradually offloaded in the current scenario despite trading at less than its fair value.

Pakistan: Exxon Is Close To Making A Mega Oil DiscoveryBy Tsvetana Paraskova - Aug 06, 2018, 2:00 PM CDT jack up rigExxonMobil is close to discovering huge oil reserves in Pakistan near the border with Iran, and those reserves could even be larger than the oil reserves of Kuwait, the Pakistani Minister for Maritime Affairs and Foreign Affairs, Abdullah Hussain Haroon, said over the weekend.

Addressing business leaders at the Federation of Pakistan Chambers of Commerce and Industry (FPCCI), Haroon said that Exxon had drilled for oil close to the Iranian border and that the U.S. supermajor was optimistic about the oil find.

“Foreign investors are interested in coming to Pakistan, provided we manage to meet their standards and attract them to make investment,” the Pakistani minister said in a press release published by the FPCCI.

According to Arab News, if the oil discovery in Pakistan turns out to be as large as expected, the country would rank among the world’s top ten oil producing countries, ahead of Kuwait.Oilprice.comJoin the world's largest energy communitywith over 10,000+ membersLearn, Share, and Discuss on the OilPrice Community

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Kuwait’s total proved oil reserves were 101.5 billion barrels at the end of 2017, according to the BP Statistical Review of World Energy 2018. The Kuwaiti reserves account for 6 percent of the world’s total proved oil reserves, putting Kuwait among the top ten countries in terms of largest oil reserves per country after Venezuela, Saudi Arabia, Canada, Iran, Iraq, and Russia.

In Pakistan, ExxonMobil signed an agreement in May this year to take a 25-percent working interest in the Indus Block G offshore Pakistan, where the other partners in the block are Italy’s major Eni and Pakistan’s Government Holdings Pvt Ltd and Oil and Gas Development Company Limited (OGDCL).

According to Arab News, Pakistan currently meets just 15 percent of its petroleum demand with domestic crude oil production, while 85 percent of its demand is met with imports. With the high imports, and the higher oil prices in recent months, Pakistan faces a large current account deficit and spends a substantial portion of its foreign exchange reserves on importing oil.

Previewing FY18 financial performance for our E&P universe, we foresee combined earnings (of OGDC/PPL/POL) to rise by 21%YoY to PkR131.5bn broadly led by: i) 25% rise in intl. oil price (Arab Light) and ii) 5.2% avg. PkR devaluation against the US$. On an individual basis, OGDC and PPL are expected to remain ahead of POL in terms of bottom-line growth, each forecasted to post 21%YoY higher earnings at PkR18.0/21.9/sh. On the other hand, adopting a conservative approach, we expect POL to declare EPS of PkR46.5/sh (due to TAL block revenue reversal). Along with the result, we expect OGDC/PPL/POL to announce final dividends of PkR3.0/6.0/22.5/sh. POL's board meeting is scheduled on Aug 15'18, while the other two are yet to announce their meeting dates. Also, it is pertinent to mention that 4QFY18 accounts have been prepared on older gas prices for TAL block, as windfall levy case still lingers in the court.

OGDC: Despite falling oil volumes (down 7.4%YoY) and stagnant gas flows due to natural decline and lack of significant additions, the state giant is set to amplify its revenue stream by 18% YoY mainly on the back of macro triggers. Moreover, recording almost 8 dry wells along with seismic acquisition in many of the Balochistan and KPK based blocks, its exploration expense is set to go up 13%YoY. On the other hand, unwinding of discount on Mari's pricing mechanism shall unlock the trickle down effect in OGDC's books. Cumulatively, the company is expected to post FY18F profit of PkR77.42bn (EPS: PkR18.0) vs. PkR63.7bn (EPS: PkR14.8) in FY17, +21%YoY. Additionally, we expect the company to declare a final dividend of PkR3.0/sh, taking full year payout to PkR10.5/sh.On sequential basis, profitability is expected to edge up 2%QoQ to PkR20.6bn (EPS: PkR4.8) vs. PkR20.2bn (EPS: PkR4.7) in 3QFY18 as revenue hike due to PkR devaluation was countered by lower flows during Jun'18